The Smugglers Bottom

On the 6th of March we set a new low at 666 on the S&P 500 only to rally all the way up again to almost 800 just after the Fed meeting last Wednesday (18th March). The rally was triggered by news from Citigroup (later confirmed by other banks such as Bank of America) that their first two months were profitable again. This made people believe we have seen the worst and from now on we can start looking up again.

During the weekend of March 14th, Fed Chairman Bernanke was lured into an exceptional TV interview where he said on tape that he saw the first green seeds of recovery in the economy. The following Monday markets rallied euphorically further.

Later that week the FOMC surprised the market again with their aggressive decision on quantitative easing. The consensus in the market was they would still take a wait and see stance.The result of all this was that markets were torn apart between the believers of “we have seen the bottom” and those who are still sceptical about it. The Fed action immediately sparked extreme volatility in the equity, currency, commodities and bond markets. The Dow Jones went from -200 points before the announcement to +200 immediately thereafter to end the session at +90. The dollar was under pressure throughout the session, trading in a 1.3416-1.3530 range against the EUR and in an 95.27-96.62 range against the JPY. The USD had its biggest fall since the G7 intervention in 2000 against the EUR and not surprisingly US 10y Treasury yields plummeted 47 bps to yield 2.535 %, the biggest drop since 1962. Gold was testing a technical resistance at 880 to rally back to 935, a 6.25 % rise.

The big question is whether we have seen the bottom indeed. If so, why would the Fed take out the most aggressive tool in history to fight the deflation monster? If there were signs of recovery deflation would certainly not be an issue with all that liquidity that has been pumped into the market so far.

Chairman Bernanke was probably right in saying they narrowly avoided a scenario which unfolded during the Great Depression. Unemployment rose above the 20% globally. At the moment there are no signs it is going to be like that, but on the other hand we are not out of the woods yet.

As said on previous occasions the current crisis is the result of imbalances and excesses built up over a long sustained period, and it will take time before we have digested all this. Global economic growth was driven by a spending spree of the US consumer.

The dynamics are well known by now. The US consumer bought goods from Asia and energy from oil exporting countries. The value of those purchases were simply larger than the US consumers’ income. The difference was funded with home equity or mortgage refinancing. In turn, the rise in mortgage debt was repackaged by investment banks. And to end the cycle all this was sold of and distributed all over the world.

It was just a matter of time before this gigantic imbalance would create a major economic distortion and to return to a normal equilibrium will take much more time then 12 months.

The US consumer will have to start saving (credit is not available anymore to the same extent as it was before 2008) (current savings rate stands at 5%+, vs. negative in the recent past !) which will cause a long period of low economic growth. The spending spree of the US consumer is felt in all layers of society. A very striking article on Bloomberg earlier this week underlines this. Stores on Greenwich Avenue, the ‘Rodeo Drive’ of Connecticut, are closing one after another. As banks and hedge funds cut jobs and close down, the stores on this exclusive avenue shut their doors too. Even a less exclusive brand as Banana Republic closed their shop earlier this month.

Further the global deleveraging process of the banking industry is best case at around 65% with a couple of USD trillion still to go. Increased government regulation and protectionism are hampering further a strong recovery. And excess capacity remains a huge problem.

All this means we will see economic growth below average, with further pressure on employment and corporate results. These are certainly not the signs that the bottom has been reached already. Otherwise, why would we see defaults of corporates of one a week on average at the moment?

Then there is the question whether the euphoria triggered by the upbeat results from Citigroup and BoA is appropriate. The banks posted a much better than expected operating profit. But operating profit says nothing about the solvency state. To be quite honest in the current is extremely attractive for banks. If one does not make a profit now when will they?

An interesting paper came out last week from Dr. Martin Weiss who runs an economic think tank in Washington. He made a thorough analysis on the banking bailout programme that is going on and he gave further arguments to believe the worst is not over yet. (1)

The Federal Deposit Insurance Corporation (FDIC) whose task is to protect deposit holders up to $ 250,000 in case a bank would fail has made a list of 252 institutions that are at risk. The total assets of these banks represent $ 159 bln.

However there is reason to believe that the FDIC is underestimating the outstanding risk and the list will be far greater:

• E.g. one of the largest banks who failed last year, IndyMac Bank of Pasadena ($ 32 bln) was not on the list.
• A number of banks, with total assets much higher than $ 159 bln, and who already received TARP money are not on the list, but this does not mean they are not at risk anymore
• Statistical rating model, developed by banking regulators, made a list of banks at risk which is more accurate then the FDIC’s list

This statistical rating model, called CAMELS ratings, takes into account capital adequacy asset quality, earnings, liquidity and sensitivity to market risk. Based upon this model Weiss Research came up with 1,372 commercial and saving banks still at risk with a total asset portfolio of $ 1.79 tln. Furthermore there are 196 savings and loans associations with $ 528 bln also at risk. Compare this with the FDIC’s number of $ 159 bln and there is reason to believe this is not over yet…

Last year in December we already referred to the exponential growth of the derivatives market causing sever systemic risk. The market already got a serious warning when Lehman Brothers was allowed to go bankrupt what the fallout of all this could mean.

The systemic risk is not going away. On the contrary due to the failure of Lehman and bailout of Bear Stearns and Merrill Lynch the systemic risk is even rising. At this moment the total notional amount of outstanding OTC derivatives is at $ 175 TRILLION. 97 % of the total amount is controlled by 5 banks!!! 49.9 % or $ 87 TRILLION is in the hands of one single bank, JP MorganChase!!!

All these banks have a credit exposure that by far exceeds their risk based capital.

Bank of America : 177.6 % ( credit risk as percentage of risk based capital)
Citigroup : 259.5 %
JPMorgan Chase : 400.2 %
HSBC Bank USA : 664.2 %

The major problem with this situation is that the US Government might not even be capable to bailout one of these banks as their exposure exceeds by far the resources the US Government has.

And the risk is not marginal. Why would for instance JP Morgan have better risk management tools as Lehman or Bear Stearns?
But stock markets are rallying indeed. Although in the past we have seen a similar phenomenon. This is a bear market rally. Figure 1 shows that in Japan they had at least 4 very strong rallies within the bear market trend. The last one was even a rise of over 55 % only to see the market resume its downward spiral. A similar trend was experienced after the tech bubble and 9/11 turned the markets in turmoil. There we can detect at least three false recoveries of 20 % on average each time (Figure 2).

Figure 1: Nikkei Index 1990 - 1999


© Bloomberg L.P. Used with permission. Visit www.bloomberg.com


Figure 2: S&P 500 1999 - 2003




© Bloomberg L.P. Used with permission. Visit www.bloomberg.com

Figure 3: S&P 500 2007 - 2009



© Bloomberg L.P. Used with permission. Visit www.bloomberg.com

In the current bear market this is only the second rebound we are seeing. From November till the beginning of this year we already saw the markets rebound by roughly 25% only to revisit new lows.

Based upon the fundamentals we just outlined above we are very sceptical the rally we are seeing right now is sustainable. Comments like “We have seen the bottom” are misplaced and will cause more pain. That’s why we call this the Smugglers Bottom. A smuggler always has a fake bottom in his suitcase to hide something behind it. This market is the same. The only difference with the smuggler will be that it ain’t something valuable behind it.

Certainly now that central banks across the globe (with the ECB the only exception at the moment but soon they will follow) are starting to bring the long end of the curve also down, sitting on cash could be so depressing that Average Joe is pushed, in a desperate search for some yield, to the stock market. He is even tempted by portfolio managers who are driven by performance anxiety and linked to a benchmark and drive prices up at the moment as the end of Q1 is coming up. The same happened at the end of last year. Managers still wanted to show some performance before the end of the year and a suckers rally was set in for the end of the year.

Forcing money into risky assets is perhaps the most dangerous experiment ever done, and is so large in scale and so unprecedented that we have no idea how it will end. I expect it to end poorly and with hyper-inflation. The funneling of assets into risk is masking the deteriorating fundamentals and giving the appearance of a market that has bottomed. But this is sleigh of hand, an illusion, a chimera.
The Fed has declared a war on savers, a war on prudence and provided the ultimate Moral Hazard Card-and with our money no less (Bernanke put anyone ?). They are also setting up the ULTIMATE BULL TRAP-a trap so large that when it is sprung, perhaps as early as the end of the first quarter/beginning of second quarter, there will only be sellers left. (2)

Following the aggressive QE of the FED we also expect extreme volatility in the currency markets in the next 24 months.

The USD will experience some further weakness in the next couple of weeks due to the fallout of the unexpected aggressive quantitative easing program from the Fed. Although it is remarkable that investors are not leaving the USD head over heels. As we said on several occasions, once there are signs of stabilisation in the US economy it will bear the fruits of the actions undertaken. In that respect the EUR might be the victim longer term given the fact that European political and monetary leaders remain clueless how to tackle the crisis. On the other hand the risk of double digit inflation due to the massive printing of money can cause a Wicksellian disequilibrium.

Just to give a brief introduction into this mechanism, economist Knut Wicksell came to the view that the effects of a disequilibrium between general demand and supply on monetary prices are not temporal but cumulative. In simple terms, any deviation from an equilibrium sets off a dynamic process that continually leads the system away from the equilibrium. If for any reason, the general demand is set and maintained above the general supply, no matter how small that gap is, the consequence will be that prices will start rising and keep on rising.

Wicksell came to his conclusion based upon the findings of his experiences in physics. “The analogous picture of money prices should rather be some easily movable object, such as a cylinder, which rests on a horizontal plane in so called neutral equilibrium. The plane is somewhat rough and a certain force is required to set the price cylinder in motion and to keep in motion. As long as this force remains in operation the cylinder continues to move in the same direction. After a while it will start rolling: the motion is accelerated one up to a certain point, and it continues for a time even when the force has ceased to operate. Once the cylinder has come to rest, there is no tendency for it to be restored to its original position. It simply remains where it is so long as no opposite forces come into operation to push it back again.” (Wicksell 1936) (3)

This also partially explains the danger of intervention by central banks and the overshooting of their targets. From now on it will be key for the FED to start preparing the markets in explaining they have an exit strategy ready. If not the problems down the road can be very worrisome.

Therefore saying that we have seen the bottom is dangerous. We even dare to say it is almost beyond belief to hear this on prime time television from the most powerful man in the world.


(1) Martin D. Weiss “Dangerous Unintended Consequences: How Banking Bailouts, Buyouts and Nationalization can only prolong America’s second Great Depression and weaken any subsequent recovery.” March 19th 2009, Weiss Research Inc

(2) John Mauldin “Setting the Bull Trap”, Investors Insight, Jan 2009

(3) Wicksell “Interest and Prices”, p. 101, 1936 Augustus M Kelley Pubs

China and its Demographics Part II

Last year in December we wrote an article about China and the demographic challenges they have to tackle in the future. A major growing issue they are facing is the potential social unrest caused by unemployed people in the cities where they are experimenting with capitalism. And this unrest is mounting. Over the last three months more then 20 million people lost their jobs due to the crisis and a drop in exports globally. A lot of those people are simply sent back to their villages inland where they were low paid farmers before they came to the big cities to look for fortune.

In our article we also referred to a possible way the Chinese government would deal with this problem, by expanding their military force to suppress the social unrests. (cfr “The Dark Theory” )

There were already indications over the last couple of years they were heavily investing in their army and last week some further confirmation hit the screens that this is the way they are moving forward and in turn will have an impact on domestic economic growth.

Chinese spokesman Li Zhaoxing confirmed that China would further boost its defence spending by raising salaries of the army and also expand spending in the further build up of their naval and space capabilities. China’s military spending will now total $ 70.3 bln on an annual basis.

Obviously, immediately thereafter came a response from the US Defence Department (David Sedney) by insisting they wanted clarification from China on the connection between its developing military capacity and strategic objectives.

It is, obviously, nothing compared to the budget that the US is spending on its military complex, $ 513 bln for 2009. However, the actual number of China is much higher (as all data produced by the Chinese government is). Based upon data from the International Institute for Strategic Studies (IISS), the official numbers don’t include overseas weapon purchases and research and development. As a consequence the IISS estimates the real number should be much closer to $ 120 bln.

Probably part of their ambition is to expand their influence in the region. What else would you do by ordering the building of a new aircraft carrier, the construction of a new space launch centre (meteorological and telecommunication service centre) for military purposes? However these investments have a much more crucial objective: a tool to keep social unrest under control.

Therefore we also argue that the recent improvement in economic data from China can be explained by an increase in their military spending. The Purchase Manager Index in February was up towards 49 coming back from 35 the month before. Also bank lending was on the rise again.

However we doubt whether this news is as good as the market perceived it. The rise of the PMI is completely due to a rise in government spending. Stocks of warehouses are still massively piling out, ships are still waiting in the ports to deliver their goods. Export numbers are still depressed.


Source: John Mauldin weekly newsletter / www.stratfor.com

Even their import numbers are falling of a cliff which is indicating that domestic demand is as weak as global demand. Therefore it makes sense for the Chinese government to ease the pain that is caused by the global recession to offset this by an expansion in government spending – read military spending. Through this, the Dark Theory becomes ever more concrete.




(1) D. Smick “The World is Curved, 2008 Marshall Cavendish

The Risk of $ repatriation

This week might be for some of our readers a contreversial topic. We would welcome any feedback on this because we can imagine this is going to raise some eyebrows. At this very moment the theme of the day remains the risk aversion of investors supporting the $. Looking further down the road there still is this phenomenal and exponentially rising debt the US is carrying and which is funded by the rest of the world. This is a serious risk hanging over the markets and could lead to a collapse of the currency. There is a broad consensus to support this view.

However during the research we did over the last couple of months we came across a couple of influential writers who threw a different view on this. We did our number crunching and must admit there is a point to be made by saying that the risk of a total $ collapse might be not that high.

Earlier last week there were already some very encouraging comments from Chinese government officials arguing they keep on having faith in and commit themselves towards their further investments in US Treasuries. Usually there is a gap between rhetoric and facts however the recent auctions in US Treasuries confirm these statements and show that investors in general keep on buying US sovereign paper.

In order to finance the current account deficit foreign investors have been willing to buy a record number of US assets. A detailed overview for 2008 is not available yet but the overall number of foreign purchases of US portfolio assets is at $ 9.5 tln. Table 1 shows an overview of the different assets held by investors outside the US.

Table 1: Foreign Holdings of U.S. securities, by type of security


Source: United States Dpt. of the Treasury

If we compare this with the total value of US citizens holding foreign securities we come out at a number of roughly $ 5 trio. This is down from $ 7.21 tln at the end of 2007. Two important things do strike us when looking at these numbers. First of all the amount of US investments foreigners are holding is almost twice as high as the amount of foreign securities held by US citizens.

Secondly the drop of foreign assets held by US citizens versus the continuous rise of foreign purchases of US assets. The more than $ 2 tln drop of foreign assets held by US citizens explains the recent rally of the $ versus EUR and £ as American investors repatriated their money over the last year rapidly. Especially in times of crises this is a typical phenomenon. Chart 1 shows the net flows of US purchases of foreign securities, with a negative number indicating a net outflow of capital from the US vice versa a positive number showing a US sales of foreign securities (on a month-to-month basis).

Chart 1: Net in versus outflows for American Investors



Source: United States Dpt. of the Treasury

Since the late nineties we see more volatile spikes. 1998 was accompanied by the Asian crisis and the implosion of LTCM, followed by late 2000 the beginning of the dotcom bubble bursting and 9/11 causing some distress among investors as well. All these periods went hand in hand with a rally in the $ across the board.

As history shows, US investors have the tendency to shy away form foreign markets for several years, after being hit by a shock. This backs our view that for the time being the $ will remain very well supported.

The current crisis clearly underlines once again (as supported by other data) the seriousness of the situation.

The good news for the time being is that foreigners are still willing to buy US assets despite the credit crunch, Fed rates going to zero and a worrisome mounting level of US Government debt. The official comment from the Chinese Government is a clear example of this and very important towards other big institutional players who consider China the leading player at the table.

However, to what extent is the risk of a repatriation of foreign investors money realistic, and could the impact be significant? Assume that ten percent of the USD 9.5 tln held by foreigners would be repatriated during a year of extreme events and let’s assume the US current account deficit would stay around the same current levels of $ 600 bio.

The end game would be the US economy suffering a balance of payments deficit of appr. $ 1.55 tln. This in turn would require American investors to repatriate 30% of the current $ 5 tln held in foreign assets to prevent the $ from collapsing. Last year the brief fall of the $ versus the EUR from 1.25 towards 1.48, may have been a simple strategic adjustment from the central bank of China by $ 60-65 bio of bonds that were shifted in European sovereign bonds. We will come back to this later on whether this is a valid point.

The next question we need to ask is whether this risk is realistic? As Table 2 shows, foreigners hold over 55 % in US Treasuries. However compared to the total amount of outstanding long-term US Securities this is less than five percent. If we add this up to the US government agency securities we still come out at a number far below ten percent of the total US capital market.

So the argument whether the high dependency of the US Treasury debt from foreign institutional investors needs to be tempered. Given the flexibility of the US capital market there is enough room of reallocation of investments by different groups of investors among different asset classes. If foreigners decided to shift their holdings of treasuries other investors would be attracted by the reduction in prices of treasuries to make switches in the opposite direction. There might be some alteration in the relative prices of the different US assets, with a modest increase in the cost of financing the federal debt, but major disruptions would be highly unlikely. This is more from an interest rate perspective.

The impact on the FX rate of the $ towards other currencies will be less positive but should also not be overestimated. It is plausible that we could see a move of 20-30%, which is already huge, like we have seen in £ or like the EURUSD move from late August last year. However a sudden unwind by e.g. the Japanese ($ 578 bio) or Chinese authorities ($ 696 bio) of their total US Treasury reserves hand in hand with a total implosion of the $ is at this stage less probable. One should not forget that both countries, who hold the largest part of US government bonds, are very much in favour of avoiding market disruptions and (this is more unfortunate) favour to maintain undervalued exchange rates to bolster even further international competitiveness.

Then there is the liquidity argument of the Foreign Exchange markets. Based upon the data from the BIS the daily volumes of the FX market were $ 3.21 tln in April 2007 (this is a survey held every three years). The FX market is by far the most liquid market in the world.

Already intuitively you might see that it is not correct to draw conclusions on flow info that e.g. a $ 60 bio bond issue coming to maturity from the Bank of China would cause a movement from 1.25 to 1.48. There are a couple of reasons for that.

As far as we know there are no theoretical studies on the impact of volumes on the price action of a currency pair. Even empirical studies are very limited since there are not a lot of data available on foreign exchange traded volumes at high frequencies. As mentioned above the BIS offers surveys on this subject only every three years.

Literature on equities and futures though gives us an indication that volumes and spreads are positively correlated. So basically we can use the bid-offer spread as an indicator how a market can swallow certain flows. As a point of reference if you would be active on a corporate desk responsible for the execution of FX flows of companies and other institutional clients, a spot trader would quote you a bid offer spread of 50 – 70 points for an order of $1 bio. One can not extrapolate this linearly for an amount of $ 60 bio but we can say for sure that a $ 60 bio amount will not move the markets by 2,300 points. One has to take into account that in a $ 2.3 trio daily market by nature there will be similar interests at the other side which will absorb a substantial part of this.

Then there is the evidence that US investors repatriated appr. $ 2 tln during 2008 back to the US. This information by itself counters the argument that a $ 60 bio flow would move EURUSD from 1.25 to1.48. Let’s even assume this would be the case, and let us assume the repatriation would have started at the top of the market, i.e. 1.60. If that would have been the case a $ 2 tln flow should bring EURUSD much lower then 1.25 at the moment.

Furthermore, based upon the above information, if the Bank of China would decide to sell its total portfolio of US Treasuries for an amount of $ 695 bio, we believe the market would be mature enough to absorb this flow. This does not mean it would not have an impact, but it would certainly not create the total implosion of the $ as many claim. There could even be some follow through from other market participants who join the move. But let’s even assume this would cause a total outflow out of the US of $ 4 tln (which is substantial) it would probably only have a similar impact as the recent repatriation from US investors we have seen.

For a total implosion one would need a complete repatriation of foreign investors US Treasury holdings. The question would be however: where to? Europe with a similar rising debt and the PIGS countries on the brink of default? The UK with a similar imploding banking system? Japan with its deflationary vicious circle? Or China which does not want a stronger renminbi and far from a transparent and developed country?

Table 2: Table 3 Value of foreign-owned US long-term securities and share of total outstanding, by asset class



Source: United States Dpt. of the Treasury

(1) Fred Bergsten and Edwin Truman “Why Deficits Matter: The International Dimension.” Peterson Institute of International Economics, January 2007.